Midterms and markets: Short-term gains, long-term pains

The 2018 U.S. midterm elections delivered the widely expected result of a split Congress. Democrats regained a majority in the House of Representatives, while Republicans maintained control of the Senate.

The market reaction was fairly muted, probably reflecting the lack of surprise. U.S. stocks briefly rallied the day after the election, but a week later the market has given back all those gains.

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What’s more, benchmark 10-year Treasury yields are actually lower and the yield curve flatter than they were in the days before voters went to the polls.

Corporate America could not have expected much more had Republicans held on to both houses. The National Federation of Independent Businesses' monthly optimism index has tracked the greatly reduced headwind from excessive taxes and red tape since the Trump election.

It should be a fair assumption that a potential slowdown in new legislation alone won’t turn the current bullish business sentiment. Maybe that’s why markets are fairly flat post-election. All the good news is priced in, but the new political landscape is unlikely to turn market-unfriendly.

However, a divided government likely means a number of critical intermediate-term problems won't be addressed for at least another two years.

One of these key issues is health care. Although attempts to overturn the Affordable Care Act (ACA) in Congress failed last year, the Trump administration and the Republican Congress have weakened the effectiveness of the ACA.

Eliminating the individual mandate has seriously undermined the revenue assumption for health insurance companies, which is pushing up plan costs. The Trump administration reacted to rising prices by allowing insurance companies to eliminate previously mandated benefits to offset the revenue shortfall.

Unless we return to the fundamental plan structure that made the ACA work, health care could once again become a serious headwind in terms of cost for consumers.

Another key issue markets have been ignoring is the dramatic increase in the federal budget deficit, which leaves the government woefully underprepared for a sudden downturn in economic growth or worse, a recession.

It’s not surprising that equity markets are ignoring such a risk and have fallen for the sugar high of surging corporate profits that have been largely bought with future generations’ taxes and not with improvement in productivity.

A sudden market rejection of the surging supply of U.S. Treasuries and a sharp increase in bond yields may very well be the biggest domestic risk to further equity market appreciation.

That brings me back to the potential benefits of divided government. It’s not that Republican control of Congress delivers a better fiscal outcome for the country.

After years of vocal opposition to deficits when Republicans were in the minority — remember the Tea Party? — what happened when the party regained the power to shape the nation’s already unsustainable fiscal path? A large tax cut and a large spending increase led to an even bigger hole in the federal balance sheet.

Relegating Republicans back to the opposition benches may rekindle the kind of fiscal conservatism that prevents further fiscal follies such as additional tax cuts or a massive infrastructure spending bill.

The irony is that President Trump, who has publicly campaigned for exactly that, may find more support in a Democratic House of Representatives. Hence, divided government may be the best defense against a further deterioration in the U.S. debt trajectory.

The 2018 midterms were an unequivocal victory for the Democrats, but the yet-unconfirmed increase in the Republican Senate majority has muddied the waters enough to prevent Republicans from recognizing that immigration isn’t the most important issue for voters.

The party that can formulate a convincing message on health care and the restoration of fiscal prudence may very well win back the center in 2020 and with that, the presidency.

Markus Schomer is the chief economist at Pinebridge Investments. Follow him on Twitter @mschomer.